Question 4. Electricity Trading (25%)

You have been hired to explore opportunities in electricity trading in the SouthEast

European region. The first thing to understand is the volatility of wholesale prices in

an emerging market and their drivers, so as to assess your risk exposure. It has been

pointed out to you that hydrologic conditions must be a key factor in price

formation: When there is a shortage of water, electricity production from hydro

plants is limited and needs to be substituted by more expensive plant technologies

(oil and natural gas). Under these conditions, prices tend to escalate, reflecting

higher fuel costs. On the other hand, when water is abundant, cheap hydro

generation becomes substantial, implying lower market shares for oil and gas

generation, which brings prices down.

Before analyzing the most recent years, you have decided to analyze first daily

market prices from two consecutive years (2008 and 2009) of varying hydro

conditions: a dry one (2008) and a wet year (2009). These two years are interesting

not only from the hydro condition perspective but also based on new entries to the

market and an economic recession.

The data is provided in the file Electricity data.xlsx.

a) Plot the data and comment on their main features.

b) Develop, analyse, and interpret a regression model for the price - demand

relationship. Is it linear and does it stay the same over time?

c) Develop, analyse and interpret a regression model, to clarify how prices respond

to demand and hydro conditions.

d) A new plant started operating in October 2009. The competition authority would

like to check whether prices declined as a result, due to emerging competition, or

whether this plant may have colluded with existing players, retaining prices at

similar levels. Can you assist the competition authority in its preliminary

investigation?

e) How would you incorporate seasonality into the model you developed in part c)?

Describe.